Payment Flexibility Insurance: Pay a 30-Year Loan On a 15-Year Schedule

You must have heard mortgage rates hit a new low. A 15-year fixed rate mortgage and a 30-year fixed rate mortgage are probably the  two most popular choices.

You must also know the tradeoffs between a 15-year and a 30-year mortgage. A 15-year loan has a higher required monthly payment, but it pays off faster, because your higher monthly payment goes to reduce the principal. A lower principal together with a lower rate means more of your next payment goes to reduce the principal. The cycle goes on and on. Over the life of the loan, you pay a lot less interest on a 15-year fixed mortgage.

Some like paying less interest but they are not sure if they can commit to the higher monthly payments. They worry if they run into some cash crunch, say one spouse in a couple loses his or her job, they won’t be able to keep up with the payment and as a result they could lose the house.

In that case some then suggest that they should take out a 30-year mortgage but pay it on a 15-year schedule. This means paying extra toward principal in normal times but falling back on the lower required monthly payments if necessary.

Is this a good plan? Yes from a cash flow point of view because it gives you flexibility. No from a cost point of view because the flexibility is not free. It’s not free because a 15-year mortgage carries a lower rate than a 30-year mortgage.

I call the cost of doing this "payment flexibility insurance" because that’s really what it is. You pay a premium for the off chance that you will need the flexibility.

How much does it cost to take out a 30-year mortgage but pay it on a 15-year schedule versus taking out a 15-year mortgage outright? It of course depends on the loan amount. The higher the loan amount, the higher the cost.

I give some examples using rate quotes from an online lender.

Example 1. Nancy refinances a $200k loan in Missouri. She can get a 30-year fixed rate mortgage at 3.75% or she can get a 15-year fixed rate mortgage at 3.125% at comparable closing costs. To pay off the 30-year loan in 15 years at 3.75%, Nancy will have to pay $1,454 per month instead of the required $926 per month. To pay off the 15-year loan at 3.125%, the required monthly payment is $1,393. The cost of payment flexibility insurance is $1,454 – $1,393 = $61/month or $735 per year for 15 years.

  30-Year 15-Year Difference
Principal $200,000 $200,000  
Interest rate 3.75% 3.125%  
Monthly payment on a 15-year schedule $1,454 $1,393 $61/month

Example 2. Bob refinances a $400k loan in California. He can get a 30-year fixed rate mortgage at 3.5% or he can get a 15-year fixed rate mortgage at 2.875% at comparable closing costs. To pay off the 30-year loan in 15 years at 3.5%, Bob will have to pay $2,860 per month instead of the required $1,796 per month. To pay off the 15-year loan at 2.875%, the required monthly payment is $2,738. The cost of payment flexibility insurance is $2,860 – $2,738 = $121/month or $1,454 per year for 15 years.

  30-Year 15-Year Difference
Principal $400,000 $400,000  
Interest rate 3.5% 2.875%  
Monthly payment on a 15-year schedule $2,860 $2,738 $121/month

How does the cost of payment flexibility insurance compare to the cost of other insurance? Maybe $735 a year isn’t too bad but at a higher loan amount, the cost is really high. $1,454 a year is more than the premium for insuring my two cars with collision, comprehensive, and the highest liability coverage. It’s also more than my homeowner’s insurance premium.

With auto and homeowner’s insurance, you are insuring against some big losses: a serious accident causing injury to others, your home burning down, etc. What do you get from payment flexibility insurance? Just relief from a temporary cash crunch.

I don’t think the cost is worth it. There are other better ways to deal with a temporary cash crunch. Beef up your investments and emergency fund. Be willing to cut back on other expenses if a temporary cash crunch develops.

You see if you make a commitment to making the higher monthly payments with a 15-year mortgage and not be wishy-washy about it, you get to save a lot of money.

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Comments

  1. Dan says

    Having your house paid off in 15 years instead of 30 will provide peace of mind in 15 years. But at what cost?

    The opportunity cost of locking that money up in the equity of your house could be significant if you invest the difference.

    According to Bankrate.com, the Annual effective interest rate for a 4% mortgage, after taxes are taken into account is 2.76%.

    With all of the money the government is printing, it is inevitable that we will experience inflation eventually. Possibly significant inflation. What is the dollar going to be worth in 15 years?

  2. KD says

    Dan, the opportunity cost you speak of is worth something now only if you can get a guaranteed return. Moreover, the deductible mortgage interest is worth a lot more at the start of the loan and essentially worth nothing at the end of the term.

    Also, inflation is not caused by just printing money. If you have a deflating economy, no amount of printing money is going to cause inflation. Given the growth rate of economy at 1 to 2% per year currently, chances of runaway inflation are minimal, but not zero.

  3. Dan says

    Thank you for the response, KD. I agree with your post. Getting a guaranteed return on the money is a challenge. I used to get a 5.83% return in our high interest checking account but that is down to 2.3%. The I Bonds that we purchased are getting 4.68% now. I’ve been researching lendingclub.com and was about to invest with them but it is currently not legal in our state. I’m open for new ideas.

  4. Harry Sit says

    Dan – Think about the investors who are ultimately providing the funds for the mortgages. Banks sell the loans to Fannie Mae or Freddie Mac and take a cut for servicing the loans. Fannie Mae or Freddie Mac takes a cut and sells them to global investors. If there’s an easy way for these global investors to do something else on a risk-adjusted basis, they will not want to pay middlemen after middlemen only for the 3.5% on your mortgage. They sure understand the effect of inflation. If they can’t find a better way with their billions of dollars, it will be very difficult for you too.

  5. Heidi says

    TFB, I realize you are a fan of paying down a mortage in 15 years instead of 30. However, what if my plan is to sell my current house and move to a more reasonably priced location (and probably downsize) prior to retirement? I’ve been in my house 5 years and would only stay here another 10, max. Although it would be nice to sell the house at that time and have no mortgage, I struggle with tieing up the funds in a paid off mortgage. My retirement accounts are maxed out, but my taxable investment account could use some additional funds (hopefully earning a higher rate than what I’d pay on the mortgage). Your view?

  6. Harry Sit says

    Heidi – Short answer is no, it doesn’t pay to carry a 30-year loan and invest the difference in the required monthly payments between the 15-year and the 30-year. I will explain in details next week.

  7. Lily says

    Great post! Most people would be shocked if they calculated how much they are paying for this insurance, even after tax. There are much cheaper flexibility insurance options, like getting a line of credit or having large emergency savings in safe investments.

  8. JimC says

    This is a very interesting discussion which shows that everyone needs to look at the actual numbers that apply to them and take into account the specifics of their situation!

    My wife and I bought our first house when I was 40 with a 30 year 9.25% mortgage.

    No way did I want to pay off that mortgage when I was 70!

    My wife, a public school teacher [a somewhat secure job], is extremely risk adverse. I was a mainframe computer programmer, and a contractor to boot, so I had no job security at all, but I am somewhat less risk adverse than my wife – mainly due to her salary and living below our means.

    EVERYONE said put your money into stocks, don’t pay additional principle on your mortgage! We did the opposite: after 4.5 years we refinanced to 15 years and 8.75%. We had nothing in stocks. We paid extra principle every month, both before and after refinancing.

    We paid off our mortgage in 13.5 years – one year after I PERMANENTLY, not temporarily, lost my job.

    Along the way my wife put 10-20% of her salary into a 403b – most of it in a Stable Value Fund, and I put 10% of my income into a 401k, 100% in an S&P500 index fund. [Since getting laid off I have been reading up on investing and our current asset allocation is more diverse, but still ultra conservative, only 30% in equities.]

    I have been out of the job market for ten years now, but unlike a large number of my former co-workers, I did not lose my house, and our retirement accounts and savings have continued to grow, despite the 2007-9 market break.

    We have no regrets about missed “potential” returns in the stock market. We saved a lot of interest on our mortgage, achieved financial security, and slept well the whole time. How many retirement accounts had a return equal to our approximately 9% mortgage savings over the past 20 years?

    Additional information:
    For our single, over 60 year old driver [100% clean driver record, 3500 miles/year] household in a NE USA city we pay $1700/year for insuring a 10 year old Buick Century, and our homeowners’ insurance is $2000/year on a house currently worth about $240,000 [our original mortgage was $90,000].

    Your mileage WILL be different!

  9. Tim Richmond says

    Savings and frugality will go a much longer way than payment flexibility insurance, and I think your numbers show that quite handily. Good post and research.

  10. nara says

    Just came across this blog, and wanted to add that I would refinance my mortgage in a heartbeat if it were not for closing fees. You forgot to account for closing fees, such as mortgage recording tax (2% for NYC since my mortgage company does not offer CEMA), origination fee (1%), attorney fee, appraisal, etc. totally 12k on a 400k loan does not make it preferable over pre-paying. I would rather have that 12k go towards my principal.

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